Companies in the consumer finance industry typically provide short-term loans to consumers and receive a fee in return. Different types of businesses in the industry require different types of collateral for these loans – including personal checks (payday), vehicle titles (title pawn), or personal possessions (traditional pawn or rent-to-own).
Regardless of the type of collateral, the raw material for companies in the industry is cash. In essence, consumer finance companies are in the business of selling cash; however, the primary raw material has become increasingly scarce since the financial crisis and the state and federal regulatory scrutiny under which the industry has been operating. Since the “freezing” of the credit markets in late 2008 and early 2009, many industries have seen credit “thaw.” This has not been the case for the consumer finance industry. Businesses in the industry continue to struggle to obtain reasonably priced capital to maintain or grow their businesses, despite a historically low interest rate environment.
From the perspective of the lender, the perception of the regulatory risk of the industry causes the lender to demand a relatively high interest rate spread (or even causes an unwillingness to lend). Lenders focus on the risks associated with the newly-formed Consumer Financial Protection Bureau and the increasingly unfavorable state and even local regulations. When lenders look at the regulatory landscape, they see it as dark and foreboding. At the same time, industry owners and executives understand these regulatory risks and are accustomed to operating in a difficult regulatory environment. When industry executives look at the business, they see a history of attractive profits and continual innovation when confronted with new regulations. Because of the continued demand for consumer finance services and the attractive economics of the industry, industry owners do not believe the risk of the industry justifies the the high cost of financing. This gap in the perceived risk and cost of financing for the industry creates a wedge that prevents companies from obtaining growth capital or refinancing maturing debt.
That said, a number of companies have been able to grow or refinance during this period. We have seen consumer finance companies obtain financing from four sources:
- Internal cash: This is the cheapest source of capital, but it is limited. The generation of sufficient cash from operations requires that operations produce relatively high returns on outstanding consumer loans. However, it is these high returns that are the target of government regulations, which seek to limit loans’ fees, renewals (rollovers), and/or other forms of return to the industry. Producing internal cash also requires significant slowdown in new store openings, as new stores are a significant use of cash in their first 24 to 36 months.
- Private placements of debt: Historically, consumer finance businesses have financed operations and growth through senior bank financing – typically in the form of large lines of credit or medium-term notes. However, much, if not all, of this type of financing has dried up for the industry. With a few exceptions, banks appear generally unwilling to extend these lines of credit, often citing the “reputational risk” of funding consumer finance operations.
More recently, we have seen successful private placements of debt replace the hole left by banks’ unwillingness to lend. These private placements, although considerably more costly than bank financing, have allowed some industry participants to access necessary capital to refinance and grow at a reasonable cost. Private placements allow the borrower to find specific investors who better understand (and/or who are more willing to accept) the risks associated with investing in the industry.
- Hedge Funds: Hedge funds are an alternative capital source. There are a large number of active hedge funds, and the capital they have under management is astronomical. While it is possible to find hedge funds that will take the time to understand the business and that would be willing to accept the peculiar risks of the consumer finance industry, it might be difficult to simultaneously find a hedge fund that provides debt capital and is set up to be longer term lender.
- Private equity groups (“PEGs”) and Subordinated Lenders (Subdebt): PEGs have the highest cost of the four; however, we have seen some interest on the part of PEGs in supplying capital for the industry. PEGs that invest in the consumer finance industry often require returns of 30% or more on their equity investments, and they often require voting control of the business, or at least a significant say in the operations. Subdebt lenders tend to require returns in the high teens or low twenties. Capital from PEGs and subordinated debt can improve liquidity and can entice other capital providers.
If your business is reaching an inflection point where it will require more capital to fund its growth, or if your business needs to refinance maturing debt obligations, we understand the challenges you face. Please contact Kim Lawrence, Decosimo's consumer finance team leader, to discuss how we can help you analyze your options and recommend a strategy for sourcing intelligent capital.